Monday, July 24, 2017

Chipotle (pronounced chi-POAT-lay): “It’s Not Me, It’s You”

Chipotle (pronounced chi-POAT-lay) reports
second quarter earnings this week, and far more interesting than the earnings
themselves—quarterly reports are, after all, backward-looking—will be whatever management
chooses to divulge about the impact of last week’s norovirus outbreak at the
Sterling, Virginia Chipotle (pronounced chi-POAT-lay), not to mention the mouse video taken at a Dallas Chipotle
(pronounced chi-POAT-lay) that went viral at about the same time as the
Sterling headlines were peaking.

We’ll dispense with the pronunciation of
Chipotle (pronounced chi-POAT-lay) from now on—we only included it because the
company does so on its Investor Relations web site, apparently on the
presumption that potential investors in CMG stock are morons who don’t know how
to pronounce that word.That presumption
stems, we think, from the world view of Steve Ells, the self-described
“classically-trained chef” who created the first Chipotle, saw its potential
and, to his everlasting credit, ran with it, and who has run Chipotle ever since.

How else to explain why Ells spent several
years telling investors on conference calls how ShopHouse, the company’s Asian
food concept, reminded him of the first Chipotle—the implication being that Chipotle
had another mega-hit in the wings—until he suddenly stopped talking about it,
and then, with no comment from Ells, the company quietly shut down all 15
locations earlier this year?(See here.)

Or the fact that, after using the 2015 annual
report to highlight the company’s “restaurateur” program devised by his high
school buddy and co-CEO Monty Moran, Ells one year later sacked Moran and put
seemingly the entire blame for uneven store performance on the restaurateur program?

Or that despite the company’s current
struggle to hit its previously-declared $10-per-share 2017 earnings target, the stock,
at 40-times that imaginary earnings
number, attracted the likes of Bill Ackman and the folks at Sequoia in a
very public manner—both, coincidentally or not after getting their heads handed
to them in Valeant?

Or why those outsiders (although Ackman is
now an insider, because apparently it worked so well at Valeant he thought he’d do
it again at Chipotle) appear to have more confidence in the Chipotle recovery
than Chipotle itself, because the company added language in its 2016 10-K
about “Risks Related to Our Plans to
Return to Sales and Profitability Growth and Restore Our Economic Model”?

In any case, Chipotle’s cynical world view appeared
on display last week when the company downplayed the number of people sickened
by the Sterling, Virginia norovirus outbreak which, according to the folks at
the Loudoun County Health Commission’s office, affected at least 60 people, while
according to the Wall Street Journal it was double that amount.

According to Jim Marsden of Chipotle, however,
the Sterling outbreak sickened only “a small number” of people.

We’re pretty sure that the 60-to-130
people who got that thing—it is not fun; some folks went to the ER, some to the
Urgent Care, and most all of them puked their brains out, because that is the
essential side-effect of the norovirus—would agree that 60 or 130 is not a
“small number.”

So, how else did Chipotle respond besides downplaying the number of people
involved?

Well, they announced a new marketing
campaign with RZA of Wu-Tang Clan, a noted food spokesman and health
advocate—wait, sorry, he’s a rapper—which
you can see here.

More importantly, they closed the Sterling,
VA restaurant immediately upon hearing the first report of an outbreak,
announced a public apology to the people who were sickened, gave them a full
refund with coupons for free meals, and suspended the Wu-Tang Clan advertising
campaign—ha!We’re kidding!

No,
they acted pretty much like the last time there was a norovirus outbreak traced
to a Chipotle: Mardsen, their food safety guy, said, “The reported symptoms are consistent with
norovirus,” which pretty much everyone knew anyway; he emphasized that “norovirus
does not come from our food supply,” which if you had gotten it at the Chipotle
and had spent a couple of days puking your brains out would seem like a distinction
without a difference; and he declared, “it is safe to eat at Chipotle.”

Oh, and they tweeted this, among other things:

And as far as that Dallas mouse video goes, they said the mice got into the store from the outside through a structural gap, not, apparently, from a nest inside the store itself. (How they determined this is not clear: the mice were not talking.)

In other words, as is always the case with Chipotle, “It’s not me, it’s you.”

But instead of delving into Chipotle’s bloodless
PR response to the Sterling outbreak, which makes Donald Trump seem almost
human by comparison, it’s more worthwhile to delve into the question of why
exactly do these things seem to happen at Chipotle, anyway?

Why isn’t McDonald’s hit with more norovirus
outbreaks than Chipotle? McDonald’s,
after all, has over 14,000 restaurants in the U.S., more than 6-times the
number of Chipotles.

Yet Mickey-D’s has had no similar
outbreaks in the last few years that we could find, while the “Food With
Integrity” folks have had three-and-counting.

Indeed, if you Google “Norovirus McDonalds” you get about 31,000 results:

But Google “Norovirus Chipotle” and you get
about 1,460,000 results:

So, what gives?

We’ll take a stab at it, because we think it exposes the key weakness in the Chipotle business model
that the Ackman/Sequoia analysis appears to ignore.

For the record, the Ackman and Sequoia
views on Chipotle, as discerned from public statements and publicly available
investor letters, are one and the same: the company has 2,250 or so stores now;
it is a long way to fixing its food safety issues; customers will come
back like they came back to Jack-in-the-Box (which actually killed people, and
yet survived); and when those customers do come back, revenues will rise back to the
$2.5 million-per-unit good old days and EBITDA margins get back to the 20%
good-old-days and the company will grow units to 5,000 stores like Ells always said
it could, in which case the stock is cheap at 40-times current, hoped-for earnings.

But the weakness in the Chipotle business
model that’s been exposed by the E. coli and norovirus outbreaks is, we think,
that the true cost and complexity of handling fresh proteins and preparing the
food right in front of the customer is order-of-magnitude more difficult than a
normal fast-food chain that uses frozen beef patties and frozen pre-cooked chicken
(even down to the grill marks on the chicken to make you think you’re eating something
that was grilled on some big mother Weber grill behind the McDonald’s).

Talk to any McDonald’s franchisee about
the move to fresh burgers the company recently announced for 2018: it’s a big supply chain headache and safety
issue.There was a good reason why McDonald’s
went to frozen patties years ago, old-timers will tell you. And while they get the need to go fresh, they know it will cost time and money.

Of course, with $2.5 million average unit
volumes, like Chipotle in its heyday, whatever it takes to get food safety secured should be easy, especially
when you don’t have to advertise, right?

Right.

But it gets tougher when the AUV is down, like it is now; and when
the unemployment rate is as low as it is now and wages are rising like they are now; and when the company is wasting money advertising with rappers at the very moment the Loudoun County health department is reporting on a norovirus outbreak at the local Chipotle.

So whatever the PR folks at Chipotle are preparing for the script on the upcoming earnings call
about the Sterling outbreak or the mouse video, or the ShopHouse failure or the
restaurateur 180 or whatever else might come down the pike at the “Food With
Integrity” joint near you, we’ll take the over on the corporate arrogance and the under on the business recovery.

JM

P.S.We love to hear from those who know more than
we do on the subject at hand because we hate to make anything up.Corrections, amplifications and examples are
welcome, with complete anonymity, of course.

Jeff Matthews

notmakingthisup@gmail.com

Author
“Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett”

The content contained in this blog represents only
the opinions of Mr. Matthews, who may have a long or short position in shares
of the company discussed here, but reminds you that this commentary in no way constitutes
investment advice, and should never be relied on in making an investment
decision, ever. The market ultimately decides
who’s right, not bloggers or company PR hacks.Also, this blog is not a solicitation of business by Mr. Matthews: the
content herein is intended solely for the entertainment of the reader, and the
author.

1 comment:

It'll be interesting to see what happens with Marsden. Prior to CMG, he was THE authority on food safety. With that quote, it appears his integrity had a price.

Also, is Acheson, another food safety expert, still involved with CMG? He was one of their biggest critics before being retained by them. If he's gone, then it's probably fair to draw some conclusions.